* The management report of Merck KGaA, Darmstadt, Germany, has been combined with the Group management report and published in both our 2015 Annual Report and our Annual Financial Statements. The authoritative German versions of the annual financial statements and the combined management report of the Group and Merck KGaA, Darmstadt, Germany, for 2015 have been led with the electronic German Federal Gazette and are available on the website of the German company register.

Internal Management System

As a global company with a diverse portfolio of products and services, we use a comprehensive framework of indicators to manage performance. The most important KPI (key performance indicator) to measure performance is EBITDA pre exceptionals.

The Value Creation and Financial KPI Pyramid, which summarizes the important financial performance measures of the Group, reflects the comprehensive framework of financial KPIs to steer the businesses and prioritize the allocation of cash resources. It consists of three managerial dimensions, which require the use of different indicators: Group, Business and Projects.

Key performance indicators of the Group and its businesses

The three key performance indicators net sales, EBITDA pre exceptionals1, and business free cash flow1 are the most important factors for assessing operational performance. Therefore, we refer to these KPIs in the Report on Economic Position, the Report on Risks and Opportunities, and in the Report on Expected Developments. As the most important indicators of financial business performance, the KPIs are key elements of our performance management system.

1Financial indicators not defined by International Financial Reporting Standards.

Net sales

Net sales are defined as the revenues from the sale of goods and services rendered to external customers net of value added tax and after sales deductions such as rebates or discounts. Net sales are the main indicator of our business growth and therefore an important parameter of external as well as internal performance measurement. In addition, acquisition- and currency-adjusted sales are used for internal performance management. Since January 1, 2015, commission income has been included in net sales.

GROUP

Net sales

€ million / change in %

2015

2014

Change

Net sales

12,844.7

11,362.8

13.0

EBITDA pre exceptionals

EBITDA pre exceptionals is the main performance indicator measuring ongoing operational profitability and is used internally and externally. To allow for a better understanding of the underlying operational performance, it excludes from the operating result depreciation and amortization as well as exceptionals. Exceptionals are restricted to the following categories: impairments, integration costs / IT costs, restructuring costs, gains / losses on the divestment of businesses, acquisition costs, and other exceptionals. The classification of specific income and expenses as exceptionals follows clear definitions and underlies strict governance at Group level. Within the scope of internal performance management, EBITDA pre exceptionals allows for the necessary changes or restructuring without penalizing the performance of the operating business.

Business free cash flow (BFCF)

Business free cash flow comprises the major cash-relevant items that the individual businesses can influence and are under their full control. It comprises EBITDA pre exceptionals less the change in the opening and closing amounts reported in the balance sheet for investments in property, plant and equipment, software, advance payments for intangible assets, as well as the change in inventories and trade accounts receivable. To manage working capital on a regional and local level, the businesses use the two indicators days sales outstanding and days in inventory.

GROUP

Investments in property plant and equipment and software as well as advance payments for intangible assets

– 609.0

– 527.5

15.4

Changes in inventories as reported in the consolidated balance sheet

– 960.1

– 185.5

–

Changes in trade accounts receivable and receivables from royalties and licenses as reported in the consolidated balance sheet

– 514.2

– 214.2

140.0

Adjustment first-time consolidation of the Sigma-Aldrich Corporation

1,219.7

–

–

Adjustment first-time consolidation of AZ Electronic Materials S.A.

–

144.6

–

Business free cash flow1

2,766.2

2,605.1

6.2

Investments and value management

Sustainable value creation is essential to secure the long-term success of the company. To optimize the allocation of financial resources, we use a defined set of parameters as criteria for the prioritization of investment opportunities and portfolio decisions.

Net present value (NPV)

The main criterion for the prioritization of investment opportunities is net present value. It is based on the discounted cash flow method and is calculated as the sum of the discounted free cash flows over the projection period of a project. Consistent with the definition of free cash flow, the weighted average cost of capital (WACC), representing the weighted average of the cost of equity and cost of debt, is used as the discount rate. Depending on the type and location of a project different mark-ups are applied to the WACC.

Internal rate of return (IRR)

The internal rate of return is a further important criterion for the assessment of acquisition projects and investments in property, plant and equipment. It is the discount rate that makes the present value of all future free cash flows equal to the initial investment or the purchase price of an acquisition. A project adds value if the internal rate of return is higher than the weighted cost of capital including mark-ups.

Return on capital employed (ROCE)

In addition to NPV and IRR, when looking at individual accounting periods, ROCE is an important metric for the assessment of investment projects. It is calculated as the operating result (EBIT) pre exceptionals divided by the sum of property, plant and equipment, intangible assets, trade accounts receivable and trade accounts payable, as well as inventories.

Payback period

An additional parameter to prioritize investments into property, plant and equipment is the payback period, which indicates the time in years after which an investment will generate positive net cash flow.

Value added of Merck KGaA, Darmstadt, Germany (MEVA)

MEVA gives information about the financial value created in a period. Value is created when the return on capital employed (ROCE) of the company or the business is higher than the weighted average cost of capital (WACC). MEVA metrics provide us with a powerful tool to weigh investment and spending decisions against capital requirements and investors’ expectations.

Capital-market-related parameters

Net income and earnings per share (EPS) and earnings per share pre exceptionals (EPS pre)

Earnings per share are calculated by dividing profit after tax attributable to the shareholders of Merck KGaA, Darmstadt, Germany, (net income) by the weighted average number of theoretical shares outstanding. The use of a theoretical number of shares takes into account the fact that the general partner’s capital is not represented by shares. To provide a more comparable view, we also publish EPS pre1, which excludes exceptionals from impairment losses, integration costs, IT costs, restructuring costs, gains / losses on the divestment of businesses, and other exceptionals as well as amortization of intangible assets as of a threshold value of € 50 million and is based on the company’s underlying tax ratio.

Credit rating

The rating of our creditworthiness by external agencies is an important indicator with respect to our ability to raise debt capital at attractive market conditions. The capital market makes use of the assessments published by independent rating agencies in order to assist debt providers in estimating the risks associated with a financial instrument. We are currently assessed by Moody’s and Standard & Poor’s (S&P). The most important factor for the credit rating is the ability to repay debt, which is determined in particular by the ratio of operating cash flow to (net) financial debt.

Dividend ratio

With the aim of ensuring an attractive return to our shareholders, we are pursuing a reliable dividend policy with a target payout ratio based on EPS pre exceptionals (see definition above).

Other relevant / non-financial performance measures

Apart from the indicators of the financial performance of the businesses, non-financial measures also play an important role in furthering the success of the company. From a Group perspective, specifically innovations in the businesses as well as the attraction and retention of highly qualified employees are of central importance.

Innovation

Innovations are the foundation of our business and will also be the prerequisite for future success in changing markets. We are continuously working to develop new products and service innovations for patients and customers. Indicators for the degree of innovation are defined individually depending on the specifics of the respective businesses.

Talent retention

Employing a highly qualified and motivated workforce is the basis for achieving our ambitious business goals. Therefore, we put a strong focus on establishing the processes and the environment needed to attract and retain the right talent with the right capabilities at the right time. To measure the success of the related measures, we have implemented talent retention as an important non-financial indicator.